Everyone likes a bold prediction, so here we go. I am calling a bottom in the telecom services stocks.

Let's review some recent events in the sector. Bernie Ebbers got fired. WorldCom (WCOM:NYSE - news - commentary - research - analysis) was downgraded by Jack Grubman and kicked out of the S&P 500. Goldman Sachs (GS:NYSE - news - commentary - research - analysis) uninvited a number of emerging telecom companies to its telecom conference. Sprint (FON:NYSE - news - commentary - research - analysis) is considering combining its two tracking stocks. The credit rating agencies are downgrading (or considering downgrading) every telecom company on the planet. Yup, feels like a bottom to me.

Let's remember how we got here. While it seems like the average telecom stock is down 95% over the last two years, the telecom business did not get 95% worse. In fact, the telecom business is not a terrible business. Though the industry has been hampered by overcapacity and a weak economy, the real story is capital structure management. As an example, why did WorldCom raise $10 billion in debt last May when its stock was trading at $15? If it had raised equity instead, we would not be debating its survival.

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So let's talk about WorldCom. I am not a buyer of the stock, but I think the company will make it. It should be able to secure bank lines that will address its liquidity needs for the next two years. Moreover, the board members own a lot of stock. While management would get fresh equity on the other side of a bankruptcy restructuring, the board members would get nothing. These guys have their lives tied up in the company, and they are not going down without a fight.

I think that they will sell off every available noncore asset to reduce debt, and ultimately, either SBC (SBC: - news - commentary - research - analysis) or Verizon (VZ:NYSE - news - commentary - research - analysis) may buy WorldCom. However, the price will look like a bargain price, not a Tiffany price, and I do not think that the government will stand in the way. Competition is not a problem in the telecom sector, and WorldCom going bankrupt is bad for a lot of people.

The Big Picture

Potential changes in the regulatory environment have cast a pall over the telecom sector. The Supreme Court decision upholding Federal Communications Commission rules governing the discounts that the Bells must offer to interexchange carriers and local exchange carriers is a positive development. The ruling basically upholds the status quo, but it diminishes the risk of adverse change from the market. Moreover, the ruling's strong pro-competitive language reduces the possibility that FCC Chairman Michael Powell will use rulemaking powers to alter the competitive landscape in favor of the Bells.

I find the Bells' pursuit of legislative, legal and regulatory relief to be almost comical. Someone needs to tell these guys that they have won the telecom battle. They have the optimal competitive environment -- a deregulated world with weak competitors. Their situation reminds me of Microsoft's (MSFT:Nasdaq - news - commentary - research - analysis) shrewd investment in Apple (AAPL:Nasdaq - news - commentary - research - analysis) several years ago.

Microsoft wanted to make sure that Apple survived as a weak competitor to mask the existence of its purported monopoly. Apple was more valuable to Microsoft alive rather than dead. Similarly, the Bells are better off with a world in which the few remaining CLECs continue to limp along. If they are successful in regulating their competitors out of business, they will emerge as true monopolists (as opposed to stealth monopolists).

My final observation about the telecom sector is that the number of bankruptcies should decline meaningfully from here. The companies with the really bad balance sheets (e.g., XO Communications and Global Crossing) are gone. While debt is still an issue for the surviving telecom companies, the scale of their problem pales in comparison to that of their ridiculously leveraged brethren. Moreover, a number of the emerging telecom carriers are improving their cash flows with lower capital expenditures, debt buybacks and bargain-basement accretive acquisitions.

Though I am calling a bottom in the telecom services sector, the risk level is very high. The best way to play this sector is with a basket of companies. So let's review a few ideas. For simplicity's sake, I will go in alphabetical order.

Companies to Bet On

Allegiance Telecom (ALGX:Nasdaq - news - commentary - research - analysis) is a competitive local exchange carrier focused on small and medium-sized businesses in 36 markets. The industry's best management team claims to be fully funded to free-cash-flow positive, with $150 million of available funds to spare. The market does not believe them. I do.

Allegiance's stock and bonds are trading at distressed levels because of fears of a revenue covenant violation, a more hostile regulatory environment and customer churn. The company has $500 million in available liquidity to fund operations, acquisitions and debt buybacks. The company has implemented a number of customer-retention measures to address the churn problem. There is a lot of risk here, but a lot of reward as well.

IDT (IDT:NYSE - news - commentary - research - analysis) is a Fortune 500 telecommunications company with the single best balance sheet in the industry. The company has a market capitalization of $1.5 billion with $1 billion in cash with no debt. IDT's telecom unit generates over $1 billion in revenue, primarily in the prepaid calling card business. John Malone's Liberty Media (L:NYSE - news - commentary - research - analysis) is IDT's largest outside investor, having recently purchased 5% of the telecom unit at an equity valuation of $600 million.

IDT owns Winstar Communications (which it bought out of bankruptcy for about $50 million), a controlling interest in Net2Phone (NTOP:Nasdaq - news - commentary - research - analysis) and the Talk America Radio Network. The company is also a plaintiff in two large pieces of litigation that could yield big judgments. IDT has been the best-performing telecom stock in the U.S. over the last five years. With its management, balance sheet and dealmaking prowess, I believe that the company is a great bet for the next five years.

Time Warner Telecom (TWTC:Nasdaq - news - commentary - research - analysis) is a fiber-facilities-based local exchange carrier in 44 metropolitan areas across the U.S. AOL Time Warner (AOL:NYSE - news - commentary - research - analysis) owns a 44% economic stake in the company, with 66% voting control. The company recently reported flat sequential revenue and EBITDA growth due to continuing disconnections in the carrier business and weak enterprise demand on the retail side. The company has $350 million in cash and $750 million undrawn on its credit facility. Thus, it does not have any liquidity issues.

The company should be a significant beneficiary of the eventual return in enterprise spending, since it offers a sustainable competitive advantage in providing high-bandwidth services. However, there is no sign of a turn in enterprise spending, so patience is required. The stock should move before the enterprise spending arrives.

Finally, we have to go with one of the Bells. Verizon trades at a P/E of just 12 on 2003 earnings and pays a 4% dividend. It is not sexy, but it should be a nice steady performer from these levels. Revenue growth should benefit from an improving economy. Moreover, the company should continue to gain entry into more markets for long-distance service. This is one that you can actually buy for Grandma.

Catching falling knives is a dangerous game. I have lost a couple of fingers in the past. But as Al Pacino said in The Godfather III, "just when I thought I was out, they pull me back in!"